Question

Phillips Enterprises Inc. is expected to pay a dividend of $2.60 next year. Dividends are expected to grow at a constant rate of 8% per year, and the stock price is currently $20.00. New stock can be sold at this price subject to flotation costs of 15%. The company's marginal tax rate is 35%. Compute the cost of internal equity (retained earnings) and the cost of external equity (new common stock), respectively.A) 0, 21.00%B) 8.00%, 23.29%C) 21.00%, 23.29%D) 23.00%, 25.48%

Answer 1

Answer:

Cost of internal equity =21%

Cost of external Equity =23.29%

Explanation:

Using the constant growth model:

$Po=\frac{D1}{ke-g}$

if ke is made subject of formula then the cost of internal equity ke is calculated as follows:

$ke=\frac{D1}{Po}+g$ =$\frac{2.60}{20}+0.08$ = 21%

If external equity is to be used, that means that the company will have to issue share to get a fresh infection of capital into the company, and is thus likely to face flotation costs. the company will  receive a net of $20 minus flotation costs for every share sold.

$Po(1-f)=\frac{D1}{ke-g}$

If ke is made subject of formula then the cost of external equity ke is calculated as follows:

$ke=\frac{D1}{Po(1-f)}+g$ = $\frac{2.60}{20(1-0.15)}+0.08$ = 23.29%